Objectives

 Definition and Basic characteristics of Insurance.

 Characteristics of an ideally insurable risk.
 Adverse selection and Insurance.
 Insurance and gambling compared.
 Insurance and hedging compared.
 Types of insurance.
 Benefits and cost of insurance to society.
Definition of Insurance
Insurance is the pooling of fortuitous losses by transfer
of such risks to insurers who agree to identify insurance
for such losses to indemnify insureds for such losses to
provide other pecuniary benefits on their occurrence or
to render services connected with the risk.

Basic Characteristics of Insurance

Pooling of losses
 Polling involves spreading losses incurred by the few
over the entire group Risk reduction is based on the
law of Large Numbers .
 According to the law of Large Numbers the greater
the number of exposures the more closely with the
actual results approach the probable results that are
expected from an infinite number of exposures.
Basic Characteristics of Insurance
Payment of fortuitous losses
A fortuitous losses is one that is unforeseen unexpected
and occur as a result of chance
Risk transfer
A pure risk is transferred from the insured to the insurer
who typically is in a stronger financial position
Indemnification
The insured is restored to his or her approximate
financial position prior to the occurrence of the loss.
Characteristics of an Ideally Insurable Risk
Large Number of exposure units
 To predict average loss based on the law of Large
Numbers
Accidental and Unintentional loss
  To assure random occurrence of events
Determinable and Measurable loss
 To determine how much should be paid.

Characteristics of an Ideally Insurable risk

No catastrophic loss
To allow the polling technique to work exposures to
catastrophic loss can be managed by using reinsurance
dispersing coverage over a large geographic area or using
financial instruments such as catastrophe bonds.
Calculable chance of loss
To establish a premium that is sufficient to pay all claims
and expenses and yields a profit during the policy period.
Characteristics of an Ideally Insurable Risk
Economically feasible premium
So people can afford to purchase the policy
For insurance to be an attractive purchase the
premiums paid must be substantially less than the
face value or amount of the policy
Based on these requirements
Most personal property and liability risks can be
insured .
Market risks financial risks production risks and
political risks are difficult to insure.
Adverse Selection and Insurance
Adverse selection is the tendency of persons with a
higher-than-average chance of loss to seek insurance
at standard rates.
If not controlled by underwriting adverse selection
results in higher-than-expected loss levels
Adverse selection can be controlled by:
Careful underwriting (selection and classification of
applicants for insurance)
policy provisions (e.g., suicide clause in life
Insurance.

Insurance vs Gambling
Insurance
 is a technique for handing an already existing pure
risk.
 Insurance is always socially productive:
 Both parties have a common interest in the
prevention of a loss.
Gambling
 Gambling creates a new speculative risk.
 Gambling is not socially productive .
 The winner’s gain comes at the expense of the loser.

Insurance vs Hedging
Insurance
 risk is transferred by a contract .
  Insurance involves the transfer of pure (insurable)
risk .
 Insurance can reduce the objective of risk of an
insurer .
 Through the Law of Large Numbers
Hedging
 Risk is transferred by a contract .
 Hedging involves risks that are typically uninsurable
Hedging doesn’t result in reduced risk.

Types of Private Insurance

Life Insurance
pays death benefits to beneficiaries when the insured
dies .
Health Insurance
covers medical expenses because of sickness or injury
Disability plans pay income benefits.
Types of Private Insurance
Property Insurance indemnifies property owners against
the loss or damage of real or personal property .
Liability insurance covers the insured’s legal liability
arising out of property damage out or damage or bodily
injury to others.
Casualty insurance
refers to the insurance that covers whatever in is not
covered by fire , marine and life insurance.

Types of Private Insurance

Private insurance coverages can be grouped into two
major categories:
Personal lines: coverages that insure the real estate and
personal property of individuals and families or provide
protection against legal liability
Commercial lines: coverages for business firms, non
profit organizations and government agencies

Types of Government Insurance

Social Insurance Programs
 Financed entirely or in large part by contributions
from employers and/or employees .
 Benefits are heavily weighted in favor of low-income
groups .
  Eligibility and benefits are prescribed by statue.
 Examples: Social Security, Unemployment , workers
Comp.
Other Government Insurance Programs
 Found at both the federal and state level
 Examples Federal flood insurance , state health
Insurance pools.

Social Benefits of Insurance

 Indemnification for Loss
 Reduction of Worry and Fear
 Source of Investment Funds
 Loss Prevention
 Enhancement of Credits
Social Costs of Insurance
 Cost of Doing Business An expense loading is the
amount needed to pay all expenses including
commissions, general administrative expenses, state
premium taxes, acquisition expenses and an
allowance for contingencies and profit
 Fraudulent Claims
 Inflated Claims
Higher premiums to cover additional losses reduce
disposable income and consumption of other goods and
services.